Play Defense in Stocks and Buy Emerging-Market Bonds, Deutsche Bank Says By Daren Fonda July 24, 2019 7:15 am ET Order Reprints Print Article Photograph by Angela Weiss/AFP/Getty Images Text size It may not pay to fight the Fed. But that shouldn’t stop investors from getting defensive in U.S. equities and playing offense elsewhere, such as emerging-market bonds, according to Deutsche Bank. In a note out this week, Deutsche’s chief strategist, Binky Chadha, points out that it is unusual for “risk assets” such as stocks and junk bonds to rally in advance of a monetary-easing cycle. Stocks historically have fallen double-digits before the Fed eased, he notes, while emerging-market equities, along with high-yield bonds, also have posted sharp declines. Risk assets now look pricey. With the S&P 500 up nearly 20% this year, the market looks overvalued by about 10%, based on economic-growth rates and leading indicators like the ISM Manufacturing index, according to Chadha. Indeed, the market appears to be pricing in a rebound in the ISM to 57 from 51.7, he writes. But don’t expect looser financial conditions, on their own, to keep the economy out of a recession. Of the Fed’s last 19 easing cycles that were in response to slowing growth, 9 episodes saw the economy eventually slip into a recession, Chadha notes. In the recession episodes, the S&P 500 went full bear—falling an average 27% from peak to trough. Most of the decline came after the Fed started easing. The S&P 500 didn’t hit bottom until an average of 5 months after the Fed began cutting rates, he adds. The big mystery now, of course, is whether the trade war keeps going. Trade frictions with China and other countries are depressing global growth. And the “Trump bump” to U.S. manufacturing has been wiped out, Chadha writes. Without a resolution to the trade war, growth may continue to slow, even if the Fed eases up a bit. Earnings estimates could start to fall in that scenario, taking stock prices with them. How to play all this? Chadha recommends buying protective put options against the S&P 500 in anticipation of a near-term pullback. Volatility is low, making the cost of the options relatively inexpensive, he writes. Indeed, put option prices are in the 35th percentile over the last 5 years, meaning they are cheaper than they have been 65% of the time. Defensive sectors such as consumer staples, real estate, and utilities have largely underperformed the market. But they all “have room to outperform” even if yields stay at current levels, he notes. Other sectors are a mixed bag. Tech is in a secular bull market that is marginally affected by cyclical growth factors, he writes. Energy and materials are in long-term downtrends. Health care, one of the year’s worst performers, is being fueled by political factors and other noncyclical issues. On the fixed-income side, Chadha recommends U.S. investment-grade bonds and emerging-market debt. Both types of bonds have historically rallied after the Fed cut rates, regardless of whether economic growth hit bottom or continued to fall, he writes. Emerging-market central banks are likely to cut rates in response to Fed rate policy, he adds, supporting emerging-market bonds. But be prepared to invest for growth if it looks like a trade deal will arrive. Chadha expects growth to rebound if a deal materializes, triggering a broad equity rally in the U.S. and abroad, and lifting high-yield bonds. And watch the ISM reading closely. Upcycles in manufacturing typically coincide with 15-month equity rallies, producing gains averaging 30%, Chadha writes. That may be a stretch this time around, considering where equity valuations are today. But if the ISM does start ticking up, there would still be ample time to get in on the next leg of the bull market. Write to Daren Fonda at daren.fonda@barrons.com
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S&P went up to 3020 levels. How idiotic are some people including at banks? Why can't they simply follow momentum? If someone is too stupid to take the free gift the Fed and Trump have given US equity markets then those individuals simply can't be helped. What will they do if shit really hits the fan?